Delaware's great idea.

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Nov. 7 2003 5:52 PM

Listening to Delaware

The best economic indicators you've never heard of, Part II.

The economic data surrounding job creation and job destruction tend to be debatable and frequently offer more grist to pessimists than optimists. The Bureau of Labor Statistics' monthly Establishment and Household Surveys, which track payroll numbers and employment figures, are based on a sampling of a small data set, not on a meticulous tally of the total number of jobs in the country. (Recently they've showed very different trajectories of job growth, which has led to controversy over their relative value.) What's more, the Establishment Survey—upon which the all-important job-creation statistic is based—can be slow to pick up the creation of new companies. As a result, it is frequently revised: Today, the Bureau of Labor Statistics reported that September payroll jobs grew 125,000, not by the less-impressive 57,000 reported just a month ago. By contrast, job loss, as measured by the number of first-time unemployment claims, is a hard, cold, real-time number; the states tally the actual number of new filings each week and forward them to Washington.

Is there an economic indicator that provides a better assessment of a more upbeat trend, the rate at which new companies are being formed? After all, the formation of new business entities would seem to be a necessary precursor for job creation. The figures on new incorporations and formations tallied by the Delaware Division of Corporations—the second installment of our Best Economic Indicators You've Never Heard Of series—may provide some valuable hints.

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Delaware is the physical home of about 800,000 people and the legal home of some 571,000 business entities, including half the nation's publicly traded companies and 58 percent of the Fortune 500. In 2000, nearly 116,000 new corporations, limited liability corporations, and limited partnerships were formed in Delaware. It's not that the citizens of the First State are so much more enterprising than their fellow citizens in larger states. Rather, the state's corporate laws and government have long been ultrafriendly to management and to new businesses. (The state offers a $1,000, one-hour incorporation service, for example.)

Because Delaware houses a huge chunk of existing businesses, and because it captures a disproportionate share of new business formation, the secretary of state's office is one of the first places one might detect economic vigor. If companies are merging and acquiring or starting new subsidiaries, if individuals are turning their one-man consultancies into 10-person consulting firms, if venture-capital-backed companies obtain another round of financing—the evidence is likely to show up first in the First State.

Here's a chart  showing the rate of new business entity formation in Delaware since 1997. As it reveals, the creation of new businesses was rampant during the last years of the boom, rising 20 percent in 1998, 17.2 percent in 1999, and 14 percent in 2000. The number of business births fell 22 percent in 2001—when the economy slipped into recession—and has been roughly flat ever since.

It's important to keep in mind that these entities could represent anything from a three-person management consulting firm to a $500 million real estate partnership. But the figures are nonetheless useful for what they tell us about the mood of businesspeople. And the mood, says Assistant Secretary of State Rick Geisenberger, can best be seen in the trend of the state's monthly tallies—i.e., comparing October 2003 to October 2002—over an extended period. (These figures aren't routinely disclosed to the public.)

In recent years, sustained economic growth has been tightly correlated with this trend. Between February 1999 and August 2000, Delaware saw 19 consecutive months of year-over-year increases, says Geisenberger. Between November 2000 and March 2002 there were 17 months of consecutive year-over-year decreases. In 2002, when the economy made halting progress, it was literally a case of six of one, half-a-dozen of another: For six of the months, the trend was up, and for six the trend was down. In 2003, business-entity formation has grown in six months and declined in three months; four of the last five months have shown greater levels of business-entity formation than the corresponding months in 2002.

It's also instructive to look at the divergent trends of new incorporations—which tend to represent activity by larger existing companies, or companies that want to go public—and of limited liability corporations, or LLCs, which usually represent smaller companies that intend to remain private. In 2001, when the stock market melted down, the creation of Delaware corporations fell sharply, by about one-third. It fell another 10 percent in 2002 and has continued to shrink this year. Thirty-five of the past 37 months have shown year-over-year declines—although September 2003 marked the first up month in 17 months. In other words, the animal spirits of large, public (or publicly minded) corporations remain largely dormant. This trend has been confirmed by the weak pace of mergers and acquisitions, the muted IPO market, and the general defensiveness of CEOs. However, LLCs have been doing well for a year and a half. "LLC growth began kicking in the middle of 2002," said Geisenberger. And the rate of LLC formation has shown year-over-over growth in 18 of the past 19 months.

Conventional wisdom holds that new companies, and specifically small new companies, would lead a recovering economy into a new era of job creation. But because of the way we calculate and tally job growth, it's a view based more on hope and faith than firm data. And until recently the government's backward-looking employment statistics have failed to detect any significant job growth. The payroll figures for both September and October were far better than economists expected, and they've been greeted with some skepticism. If we'd been paying attention to Delaware's recent data on corporate formation, we might have been a little less surprised. Those numbers might even inspire some cautious optimism.

Daniel Gross is a longtime Slate contributor. His most recent book is Better, Stronger, Faster. Follow him on Twitter.